In my previous article, What is the Best Way to Calculate College Costs?, I shared 4 steps to help you build a college fund for your child or grandchild. In it, I also touched on the types of college savings plans, called 529 Plans that are available.
At our firm, Glassman Wealth Services, our clients who want to save for their loved one’s college education often ask us to help them decide which plan best meets their needs. There can be a lot of confusion when having to choose a specific plan since there is a wide array of plans available and most states and some private institutions sponsor their own.
But without a knowledgeable financial advisor, where do you start? How do you narrow down the list of available 529 plans to the one that is best for you? In this article, I plan to focus on helping you know which 529 college savings plan may be right for you.
First, start with deciding on the type of 529 plan you’d like to use – a Pre-Paid Tuition Plan or Savings Plans. Then, it’s a matter of evaluating the options and choosing the one that will provide the biggest benefit.
What are the Two Types of 529 Plans?
While there are distinct differences between the two types of plans, they work similarly and have three key benefits:
- Contributions grow tax-free if used for qualified education expenses
- You may be able to write off contributions on your state tax return
- Dollars in a 529 plan are outside of the grantor’s estate, and you may continue to have control over whom the beneficiary is and how the dollars are invested.
1. Pre-Paid Tuition Plans let you to lock-in today’s tuition rates. Semesters or years of tuition can be purchased and later redeemed for the student at participating colleges. The details are very specific to each plan.
While these can only be used for tuition and fees, it is an attractive option to control future college costs. The down-side? The student elects to attend a college that does not participate in the pre-paid plan you chose. In this case, the credits may have a lower value than expected, or you may simply receive a refund of your money.
Best for: Those who are willing to accept more restricted geographical areas or college choices for the chance to lock-in today’s price for tuition and fees.
2. Savings Plans work like an investment account where dollars are deposited and invested. The value of the account is subject to the markets and the investments that were selected.
There is greater flexibility since tax-free withdrawals can be used for tuition and fees plus other qualified expenses, such as room, board, books, and supplies. Also, the student can use the dollars at any college, university or secondary education institution, with no loss of value. Contributions are limited to the annual IRS gift amount (currently $14,000 per person per beneficiary in 2014), but a special rule allows a large lump sum deposit that can be counted as a 5-year gift.
Best for: Those who are comfortable with investment risk and want the flexibility to use the dollars at any college or secondary institution for any qualified education expense.
Deciding Which College Savings Plan to Use:
Most people don’t realize that they are not beholden to only using the 529 plans available in their home state, so it pays to shop around. Depending on the type of plan, there are different factors to consider.
Pre-paid tuition plans: These can be difficult to evaluate since they are specific to each state. However, there are several factors that can be compared across plans:
- Purchasing units or contracts: The cost of a unit or contract is structured around the current cost of public in-state school tuition and fees. A unit would cover a percentage of tuition and just as the cost can vary between state schools, so can the number of units necessary to cover a year of tuition. A contract allows the purchase of a specified number of years of tuition, possibly offering an advantage to younger children by offering a lower rate.
- Financial aid treatment: Some states will exclude the value of the plan for state financial aid purposes.
- Age limit: most plans limit or eliminate the ability to contribute after the beneficiary reaches a certain age
- Out-of-plan value: in the event that the student attends a college that does not participate in the pre-paid plan, it’s important to know your options, such as the value that can be applied to out-of-plan college tuition or the amount you’ll get back if you cash out the plan.
Savings Plans: When choosing a 529 College Savings Plan, there are a few things to consider:
- Fees: Fees are a big factor given that any dollars going toward commissions, investment management, or administrative costs will reduce the dollars available for college expenses.
- Investment performance: The investments play a large role in growing the dollars beyond the deposits and really getting the benefit of the tax-free growth.
- Any state-tax benefits: Not all states allow a state-tax deduction for contributions, but if your state does, the additional tax savings could be a compelling argument for going with the plan in your home state.
Top College Savings Plans:
Since this question is posed often, many independent companies rank plans based on fees and performance. The plans below are consistently rated as top in the country:
To find out more, Morningstar’s 529 Plan Center is an amazing resource that shows the 529 plans available in each state and how they stack-up.
Understanding your college savings options and how much to save can be challenging. That’s why we put together this College Savings Guide. You’ll find what you need to know to make the best decision for you and your future college student.